The writer is vice-chancellor of the Pakistan Institute of Development Economics

Leading economists like John Maynard Keynes and Irving Fisher had forecast prolonged and permanent prosperity, just prior to the Great Depression of 1929. The shock of the Great Depression led Keynes to create Keynesian Economics. According to conventional economic theory, increasing the quantity of money in circulation has only one effect: increasing the level of prices. That is, printing money is inflationary and has no effects on the real economy. Many economists of the time noted that massive bank failures had led to substantial reduction in the money supply. They came to a realisation that these events were related. Contrary to the classical theory that money only affects prices, there was a possibility that shortfall in the money supply caused the massive unemployment of labour and other resources.

Keynesian theory is based on a very simple idea that conduct of the ordinary business of an economy requires a certain amount of money. If the amount of money is less than this amount, then businesses cannot function — they cannot buy inputs, pay labourers or rent shops. This was the fundamental cause of the Great Depression. The solution was simple: increase the supply of money. Keynes suggested that we could print money and bury it in coal mines to have unemployed workers dig it up. If money was available in sufficient quantities, businesses would revive and the unemployed labourers would find work. By now, there is nearly universal consensus on this idea. Even Milton Friedman, the leader of the Monetarist School of Economics and an arch-enemy of Keynesian ideas, agreed that the reduction in money supply was the cause of the Great Depression. Instead of burying it in mines, he suggested that money could be dropped from helicopters to solve the problem of unemployment.

But what about inflation? Isn’t it true that printing money in massive quantities would lead to inflation? According to Keynesian theories, this would happen after full employment was achieved. That is, once the economy reached its maximum production capabilities, further money could not contribute to an increase in production. At this point, printing more money would only lead to inflation, exactly as the classic economic theory predicts. The Keynesian theory gives the central banks of the world an extremely important task: maintaining the money supply at exactly the right level to create maximum production without running the risk of inflation. Keynes also said that monetary policy may be insufficient for the task and the government had the direct responsibility of ensuring full employment using fiscal policies.

Regulation of financial markets, social support for the poor and the governmental responsibility to provide jobs for all led to decades of prosperity in Western economies. The share in the wealth of the bottom 90 per cent increased, while the share of the top 0.1 per cent decreased. This state of affairs did not please the wealthy elite, who launched an extremely successful attack against Keynesian ideas in the 1970s. The Arab oil embargo led to a sharp rise in oil prices and inflation, while simultaneously disrupting productive activities and creating unemployment. Keynesian theories state that we can only have one or the other: ‘stagflation’ or simultaneous presence of high inflation and high unemployment is ruled out.

This weakness in the Keynesian theory was successfully exploited by the rich and powerful to argue that the main problem lay with government interventions. Ronald Reagan dismantled some post-Depression regulations, which limited the powers of wealthy financiers. In particular, with great fanfare, Reagan deregulated the savings and loan (S&L) industry. Exactly as in the Great Depression, the banks took advantage of this to speculate in risky investments with depositors’ money and lost billions of dollars, creating a nation-wide banking crisis. However, the US government had learnt its lessons from the Great Depression and gave a massive bailout to prevent the collapse of the S&L banks. Over the next few decades, deregulation unleashed the power of the financiers, and cuts in social services weakened the labour class, with predictable results. Speculative financiers gambled heavily with the money of others deposited in banks, leading to myriad monetary crises. At the same time, the labour class was squeezed, resulting in rising inequalities and massive concentration of wealth at the top.

In the post-Keynesian era, the clarity of Keynes has been lost. Many central banks have gone back to pre-Keynesian ideas, abandoning the goal of full employment, and focusing solely on controlling inflation. Substantial doubt has been created as to whether or not monetary policy, or helicopter money, can be useful in solving problems of unemployment. When countries spend more foreign exchange on imports than they can earn, they are forced to borrow dollars from the IMF. As a condition of such loans, the IMF insists on austerity — governments should balance budgets and not print money to finance deficits. According to the IMF, financing deficits with increases in money supply can lead to high inflation, with heavy economic costs. However, according to Keynes, we should increase the money supply in an economy with high unemployment, such as Pakistan. Printing money is not inflationary in such a situation. So who is right? Keynes or the IMF?

Recent research by Princeton economists Atif Mian and Amir Sufi sheds considerable light on the answer, which is obvious in retrospect: both Keynes and the IMF are right. What happens depends on who picks up the helicopter money and what they do with it. If those who get the money buy land, property values will go up. If they invest in stocks, this will create a bubble in the stock market. If they put it in their Swiss accounts, this will lead to depreciation of the exchange rate. However, if the money is used wisely, to invest in projects which increase the productive capacity of the economy, this will create employment and generate the economic returns needed to provide support and backing for the newly created money.

When Keynesian policies of full employment and social support for labourers eroded the wealth shares of the elite, the counter-attack created alternative policies, as well as theories and ideologies to support these policies. Decades of experience with these policies, codified in the Washington Consensus as privatisation, liberalisation and stabilisation, has shown that they produce increasing inequality but do not produce growth. Alternative models for successful development are available. The most spectacular recent example is of Brazilian leader Luiz Inacio Lula da Silva. After being elected president in 2003, his deficit-financed programmes of social support and investment created progress and prosperity. Under him, Brazil went from being the most heavily indebted country in the world to the eighth largest economy, and 20 million people rose out of poverty. There are many other examples of wise public spending listed by Ellen Brown in The Public Bank Solution: From Austerity to Prosperity. Other kinds of examples also exist, where reckless and corrupt governments can wreak havoc on the economy, as the IMF fears. Can we rise to the challenge of spending efficiently on social services and productive investments, leading to the Keynesian outcomes of full employment without inflation?

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Reader Comments (12)

Pakistan is a unique case study.Here both Kenyesian and IMF inspired reforms have miserably failed to bringabout any positive change.In Pakistan there is a lack of spirit of nationalism.Here both elite and man in the street are anxious to move and settle abroad.The nexus of politicians and bureaucrats is hoodwinking and looting the masses by twisting and turning rules to their favour.Pakistan need a radical change in the mindset of masses to make the system accountable and pro poor.When everything is left to God this leads to indifference and worst kind of exploitation.The proper study of mankind is man.Recommend

Pakistan needs to increase money supply to produce electricity and build dams this will leads to increase in production and employment creation ultimately this will benefit the economy instead of spending on non productive options. Recommend

This is exactly what I have been pondering over for the past few years. I believe that as long as an economy is operating at a level below it PPC, there should be room for real growth without inflation – as inflation would become necessary for producers to produce at a point where the economy is operating at its full potential. This can lead to achieving another goal at which the Pakistani society aims which is of zero interest rates. no inflation in theory should translate into zero real interest rates. real GDP growth can be achieved by taking the economy from below PPC to a point at the PPC just by allocating and employing resources where they are missing.

This is do-able all it would require is channel through which savings or government borrowing is invested for profits and not fixed returns whereby the profits are distributed pro-rata to the owner of the investment.Recommend

@realeconomist yes, I understand that its two dimensional but theoretically it does hold. All of the “real world” things are a function of some theory. the only thing is that within a function the error term is the unknown which may be further variables that are not defined. suppose that we uncover those unknown variables then our function would be complete and would hold for all values of x.

And also, i’m not writing this to “impose” my opinion onto others let alone the economy. it is a question posed by the author of this article to which I simply agree that we can achieve full employment without inflation – which if you think about it, is possible.Recommend

When the government prints money and uses it to improve the quality of the infrastructure, the effect is mostly beneficial to the degree of employment. There are however a few snags which were not mentioned above.

The method by which the government prints the money is by the exchange of treasury bills on which interest is paid. So the more money that is borrowed, the greater the sum of interest on it which is pf course borne by the dear old tax payer.

The better infrastructure makes the land more valuable and useful. Consequently this policy improvement gives unearned benefit to the land owners. They find that the more productive land can call forth more rent. Speculation in its value (due to the associated developments in rural regions which gradually become urban), makes it worthwhile to withhold it and to charge more (due to the competition) for what is in use. These parasites have done nothing, yet their holdings have risen in value and the pickings are so rich that they happily seek to learn what developments are being planned, and the local municipal offices become their targets for this kind of corruption.Recommend

Kenynes may be right during time of great depression. Now if the money is hidden in mins, people will not be hired to dig it out. Automated tools are robots will do the job and money will land up in pockets of powerful pople already holding most of the money anyway.Recommend

However, if the money is used wisely,
to invest in projects which increase
the productive capacity of the
economy, this will create employment
and generate the economic returns
needed to provide support and backing
for the newly created money.

This is difficult to do in Pakistan because of the energy shortage. Fix that and credit to the private sector can be spent productively. To fix the energy shortage you need to fix the law and order situation. Most of our problems will go away if we fix law enforcement in Pakistan.

Under him, Brazil went from being the most heavily indebted country in the world to the eighth largest economy, and 20 million people rose out of poverty

There are two things the author forgets to mention about Brazil. One they have a tax to GDP ratio comparable to developed countries. It is 35% or so. Ours is more like 9%. Brazil can afford to spend on social services and infrastructure.

Second Brazil enjoyed the benefits of the commodity price boom which was fueled by the US Fed’s QE and China’s rise. Now that QE has ended and the Chinese economy is no longer running at full steam the Brazilians are also feeling the heat.Recommend

I would respectfully disagree.
I have a lot of respect for Mian and Sufi and their work but you never mention which paper youre referring to since I havent seen a paper from them that handles the question youre asking… they have the cash-for-clunkers paper which might be applicable at sight but that would be misguided since they are doing a partial equilibrium analysis while keynes argued for a general equilibrium analysis…
The monetarist ideas are not just purely based on theory, they are based on simple facts as well. Government, with having control of money supply AND fiscal policy, results in extremely inefficient spending and inflation and monetarization of govt debt. Nice examples of this are Latin American countries in the 80/90s and post WW1 European countries…
Since the days of Keynes, we, as economists, have learned a lot!
We understand the ideas of mechanism design, incentives, efficiency, provision of public goods, etc…
The best way for most counties is exactly what the IMF has proposed. These ideas are based on very very sound theory and empirical calibration of the theory.
What is the problem then?
Pakistan is a classic example of why IMF’s ideas are ‘failing’. Very competent economists at the IMF provide very good reform programs that are, either never implemented by the home countries (since it hurts the rulers’ ability to stay corrupt) or are not pushed by the politicized IMF based on global political considerations.
The IMF doesnt need to change the way its recommendations are compiled, more force itself to ensure those recommendations are followed through!Recommend

The above analysis does not seem to take into consideration the nature of currency. Increasing the supply of dollars (worth gold in in international market) would give different results than increasing the supply of Pakistani rupees. I would argue that increasing the supply of rupee would further devalue the currency and it wont get translated into real value that easily even if the govt tries to spend it on infrastructure development.

The organization of labor in Pakistan could either be brought about using influx of foreign capital or some more socialistic mechanism not relying on local capital. Recommend